What’s Wrong with Monopoly?

1. What’s Wrong with Monopoly? Why do property and trade lead to efficient outcomes? You use something if and only if its value to you is greater than its cost to you The price you pay is the cost of producing it So you use things if their value to you is greater than the cost to the producer, and similarly Greater than the value to anyone else, since you were willing to pay a higher price than anyone who didn’t get it Similarly for inputs; “least cost” production in money is also “least cost” in human values Why does price correspond to cost? If it costs me $10 to produce one more widget And they sell for $11 It is in my interest to produce more And the process continues until price driven down, or cost up, so they are equal

2. Suppose there is only one producer • I can produce as many widgets as I want at $10/widget • Currently, I sell 1000 widgets/year @$12/w • Revenue: $12,000, cost $10,000 • Profit: $2,000 • I could sell 1100 @$11/widget • Revenue $12,100. Cost $11,000 • Profit $1,100 • Or 1200 @$10/widget. Profit=? • The argument for price=cost • Assumed I can sell more without driving down the price • A reasonable assumption if there are many firms • But not if there is only one • So a monopoly will sell at price>marginal cost

3. What is Wrong with Monopoly • Price>MC means that • A consumer who values the good at >MC • But <P doesn’t get it • Although producing it for him produces a net gain in efficiency • Since value to him is more than cost to produce • Also a rent seeking problem • If there is only room for one firm • And the first firm gets the monopoly • There is an incentive to enter inefficiently early • So as to make sure your firm gets the monopoly • Just like the homesteading problem discussed earlier

4. The second efficiency conditon • One requirement for efficiency is • That everyone who values the good at at least its cost gets it • And P=MC produces that result • The other is that the product only be produced if the total value>total cost • Consider a computer program • MC=$1.00 (to copy a CD, package it) • Fixed cost of writing the program=$10,000,000 • If you sell it at MC, 10,000 are sold • And you somehow know that at $10 none would be sold • Benefit to consumer is from 0-$9 • Total benefit from 0-$90,000 • It wasn’t worth writing the program • How do we arrange to satisfy both conditions?

5. Why is Monopoly? • State Monopoly • Natural Monopoly • Cartel • Artificial Monopoly

6. State Monopoly • The original meaning of the word • Illegal for others to compete • Salt monopoly, say, used to raise revenue • Modern versions include • Government monopoly: Post Office • Regulated industries: Several firms but • New firms not free to join • Existing firms not free to compete on price and service • More nearly a cartel (see shortly) than a monopoly • Examples • Airlines before deregulation • Trucking • Barbers where the city licenses them

7. Natural Monopoly • Due to economies of scale and the size of the market • The more you produce the more cheaply you can produce? • Sometimes, for some range of output • Your design costs get spread over more units, but … • More layers of control between the president and the factory floor • So cost falls and then eventually rises again • Natural monopoly if a firm big enough to produce for the entire market has lower costs than any smaller firm • That might be a big firm in an industry with a lot of economies of scale • Or a small firm in a very small market • Geographically small: General store in small town • Niche market: Me as a public speaker • In either case, the economic analysis of monopoly applies.

8. Cartel • Suppose economies of scale are not quite big enough • Big firms beat small firms • But there is room for multiple big firms • And still bigger ones don’t beat them • The firms make a deal • “I’ll keep price up, quantity down, if you do” • Multiple firms functioning like a monopoly • Problem 1 • It is in each firm’s interest to cheat on the deal • Sell a little more at the high price • Solutions • An enforceable contract--not legal in the U.S. • Government regulators controlling output and price • Watch each other very carefully • Problem 2: Preventing entry of new firms • Problem 3: The smallest members have the most power • If the Saudis increase output, the cartel breaks • If Venezuela does, will anyone believe Saudi threats to do the same? • So the biggest members have to bear most of the cost of holding down output

9. Artificial Monopoly • Suppose I have a very big firm • I am not a natural monopoly--my costs are not lower. But … • Since I have more money than the small firms • I can sell below cost to drive them out • And become a monopoly • What is wrong with this story? • Suppose I am ten times as big and as rich • Selling below cost I lose money ten times as fast • Probably faster--I have to sell as much as people want to buy at the low price • My competitors don’t. • Who goes broke first? • And if I somehow outlast the competitor • What keeps him from selling out his plant to a new competitor • At a point when I am almost out of money?

10. What can be done about monopoly? • By the government • Regulate? How • Government ownership (Post Office) • General legal rules • Such as not enforcing cartel agreements • Or permitting merger to monopoly • By the monopoly • Consumers with P>value>cost • Are not only a problem for efficiency • They are lost revenue for the monopoly • Price discrimination might solve that • Find a way of selling at a high price to those willing to pay it • But at a lower price to those who aren’t • Discriminate both among customers and among units bought by a single customer

11. Regulation • Order the monopoly to sell at marginal cost? • How does the government know what MC is? • There are fixed costs as well; if the firm cannot cover them it goes broke • If the government offers to subsidize them, how does it make the monopoly minimize its costs? • Or know if the firm and product should exist? • If government is willing to subsidize the fixed cost • The firm covers its cost even if the good not worth producging • So how do we take care of the second efficiency condition? • Order it to sell at average cost? • Standard utility rate regulation • Price is still inefficiently high, and … • Either regulator has to know what AC should be • Or observes costs, lets firm set price to cover them • So why should the firm hold costs down? • At least, firm will not exist if total value<total cost (why?) • But might not exist even though total value>total cost (why?) • And if the regulator could produce efficiency, why would he? • We can predict that the firm will try to maximize its profit • What makes it in the interest of the regulator to maximize efficiency?

12. Government Ownership • With the best of intentions • How does the firm get the information to know • If its existence satisfies the second condition? • It sets P=MC, makes up fixed cost from taxes • It observes how many consumers value>MC • But not by how much more • So doesn’t know if the taxes are buying a benefit worth the cost • Why should it have the best of intentions? • Post office jobs can reward political supporters • Contracts can be sold for campaign donations • How do we make it in the interest of a government run firm to try to maximize economic efficiency? • Or shut it down if it isn’t worth running?

13. Problem with Both • Consider a private natural monopoly • As things change, it may cease to be a natural monopoly • And lose market share to new competitors • Suppose it is a regulated monopoly? • It may be able to get the regulators • To keep out the competitors • Airlines, Railroads, Trucks • Suppose it is a government run monopoly? • Likely to be a monopoly in the old sense too • The people running it believe in what they are doing • Post Office

14. Preventing Cartels • Not enforcing cartel agreements • Indeed, trying to punish them • If detected • Firms might merge--perhaps lose some efficiency but solve the cartel problem • So restrictions on merger to monopoly • But … what about mergers for effciency? • One elegant but impractical solution is … • Ask other firms if they approve of the merger • If they do, forbid it • If they don’t, approve it • Because?

15. Price Discrimination • Ideally, a monopoly wants to • Sell every unit for which value>MC • At the highest price the customer will pay • One approach is to separate markets • Sell book for high price in U.S., low in U.K. • Offer cheap standby tickets only to youths • Sell hardcovers for more than paperbacks • By substantially more than the cost difference • The real fans will want the higher quality • And the earlier publication • Another is different prices for one customer • Customer values tenth cookie less than the first • So $1/cookie up to five, $.50/cookie beyond that • Suppose cost is all fixed (Disneyland rides at below capacity) • Charge an entry fee, make rides free • P=MC=0, entry fee up to total value to customer • If done perfectly, this meets both efficiency conditions • Two problems • Seller must know enough to charge the right prices, and … • Be able to prevent resale • I buy 100 cookies, sell five each to 20 people for $.80/cookie • Harder to do the equivalent for the Disney ride! • So price discrimination easier for services consumed on the spot

16. Why is Price Discrimination Interesting? • It provides a possible solution to the problem of efficient outcomes • Can be used to get closer to “everyone buys it who values it at its cost • But whether PD increases efficiency turns out to be ambiguous • Perfect PD solves that problem, imperfect could make it worse • And PD increases the rent seeking problem (why?) • It provides a possible explanation for why firms do things • Consider tie-in sales • If you buy our printer, you must use our paper • (IBM card sorter and IBM cards in a later case) • Such terms have been found illegal under antitrust • Before deciding if they should be illegal, first question is • Why does the firm want to do it?

17. Why Tie-in Sales? • Old theory: “Leverage your monopoly” • IBM makes the only (?) card sorters • Use that monopoly to get a monopoly on cards • Problem • Purchaser needs sorter and cards; what matters to him is the total cost • So the more IBM charges for cards • The less they will be able to get for the sorter • IBM should let card producers compete down price to MC • And collect the whole profit off a single monopoly • Solution: Price Discrimination • Firms that use the sorter a lot use lots of cards • And probably get lots of value from the sorter • So high priced cards are an indirect way of • Charging more to the high value users • A point made explicitly in the much older printer case

18. Vertical Integration • You have a monopoly of steel production • So use it to get a monopoly of autos • In order to “extend your monopoly” • “Get two monopoly profits” • But you could push up the price of autos • By what you charged auto producers for steel • Let them compete down their margin • While you collect the monopoly profit • If autos not a natural monopoly, that makes you more money • So why does vertical integration exist? • Because it is sometimes less costly to produce in house • Because it can reduce the inefficiency from monopoly pricing • Suppose steel costs you $10/ton to produce, you sell it to auto firms for $20/ton monopoly price • In deciding how much to use, they compare costs at $20 • Which means inefficient substitution of aluminum etc. • If you make the autos, do internal calculations at $10 • Produce at minimum cost--then sell cars at a monopoly price

19. Retail Price Maintainance • Producer sets a minimum price • Retailers may not sell for less • If they do, they don’t get the product any more • Legally restricted but forms still exist • Again, conventional argument is • Producer is getting a second monopoly • On retailing • By preventing competition between outlets • Again, it doesn’t work, because • Producer can force up retail price via his price • Let retailers compete down their margins • And so he gets all the monopoly profit • Why does it happen? • Perhaps to encourage rent seeking? • P>cost, pays to spend money on advertising, support • Even though some of it benefits other stores • And all of it would if they were free to cut their price instead

20. The Real Problem Is • Not the existence of a (natural) monopoly • Breaking it up would just raise costs • Regulation has problems similar to those of monopoly • But the existence of conditions inconsistent with a competitive market • I.e. economies of scale • That run up to the full size of the market • Without competition, only bad answers • Private single price monopoly • Private monopoly with price discrimination • Regulated monopoly • Government owned monopoly • But better answers to • Government created monopoly or • Cartel • Since there competition may be an option

21. Network Externalities • The idea • The value of a good to me might depend • On how many other people are using it • Querty keyboard, MS Word, English language • So once one version somehow becomes dominant • Everyone wants to use that • Even if an alternative would be better for everyone • Consider driving on the left in England • So outcomes could be path dependent • Some random factor early in a technology • Puts us on the wrong path • Perhaps we could avoid that, or … • Switch paths--as Sweden switched to the right

22. Is it a real issue? • Example used to be the Qwerty keyboard • Until Liebowitz and Margolis looked into the history • And found that all the asserted facts were false • It wasn’t • Designed to slow typist down • Successful due to one typing contest • Hard to switch keyboards • Much inferior to the later Dvorak layout • Similar criticisms have been made of other supposed examples • Of inefficiency due to path dependence • By Liebowitz and Margolis in their book • If network externalities are large • The dominant product should still be dominant at a higher price • Giving its seller more profit • But that doesn’t seem to be how sellers act • L&M argue that the actual economics of software • Is a natural monopoly of the currently best • With sequential competition • As better competitors appear, become dominant • Visicalc, Lotus, Excel • WordStar, WordPerfect, Word